consumer demand theory ii session 3, ea 4 th july, 2007 prof. samar k. datta
TRANSCRIPT
![Page 1: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/1.jpg)
Consumer Consumer Demand Theory IIDemand Theory II
Consumer Consumer Demand Theory IIDemand Theory II
Session 3, EASession 3, EA44thth July, 2007 July, 2007
Prof. Samar K. DattaProf. Samar K. Datta
![Page 2: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/2.jpg)
Overview of items intended to be covered in this session
• Consumer Choice
– Interpretation of consumer equilibrium: Equi-marginal principle
– Corner solution
• Diminishing MU & diminishing MRS• Income effect and distinction between normal and
inferior goods• Engel curve• Price consumption curve and demand curve• Substitutes and complements • Examples /Food for thought
![Page 3: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/3.jpg)
Two conditions for optimal consumer
choice1) Must be located on the budget line.
2) Must give the consumer the most preferred combination of goods and services (i.e., maximum satisfaction).
![Page 4: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/4.jpg)
U2
Consumer ChoicePc = $2 Pf = $1 I = $80
Budget Line
A
At market basket A the budget line and theindifference curve aretangent and no higherlevel of satisfaction
can be attained.
At A:MRS =Pf/Pc = .5
Food (units per week)
Clothing(units per
week)
40 8020
20
30
40
0
![Page 5: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/5.jpg)
• When consumers maximize satisfaction:
CF/P PMRS
CFC F /P P /MUMU
Marginal utility andconsumer choice
• Since MRS is also equal to the ratio of the marginal utilities of consuming F and C:
![Page 6: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/6.jpg)
• The equation for utility maximization can be alternatively expressed as:
CCFF PMUPMU //
Marginal utility andconsumer choice
![Page 7: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/7.jpg)
• Total utility is maximized when the budget is allocated so that the marginal utility per dollar of expenditure is the same for each good.
• This is referred to as the equal marginal principle.
Marginal utility andconsumer choice
![Page 8: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/8.jpg)
A Corner Solution
Ice Cream (cup/month)
FrozenYogurt
(cupsmonthly)
B
A
U2 U3U1
A corner solutionexists at point B.
![Page 9: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/9.jpg)
Condition for corner solution
•MUX/PX > MUY/PY
•Implications of corner solution:
brand loyalty at any price?
![Page 10: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/10.jpg)
Questions on diminishing MU & diminishing MRS
• Does diminishing MRS necessarily imply diminishing MUs?
• Does diminishing MUs necessarily imply diminishing MRS?
![Page 11: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/11.jpg)
Income Changes, Income Consumption Curve, and Shift in Demand Curve
• Income Changes– An increase in income shifts the
budget line to the right, increasing consumption along the income-consumption curve.
– Thus, increase in income shifts the demand curve to the right.
![Page 12: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/12.jpg)
Income Consumption Curve
Food (units per month)
Clothing(units per
month)
An increase in income,with the prices fixed,
causes consumers to altertheir choice ofmarket basket.
Income-Consumption Curve
3
4
A U1
5
10
B
U2
D7
16
U3
Assume: Pf = $1 Pc = $2
I = $10, $20, $30
![Page 13: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/13.jpg)
Income Changes & Shifts in the Demand
Curve
Food (units per month)
Priceof
food
An increase in income,from $10 to $20 to $30,with the prices fixed,shifts the consumer’sdemand curve to the right.
$1.00
4
D1
E
10
D2
G
16
D3
H
![Page 14: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/14.jpg)
Normal vs. Inferior Good
• Normal Good - The income-consumption curve has a positive slope:
• The quantity demanded increases with income.
• The income elasticity of demand is positive.• Inferior Good - The income-consumption
curve has a negative slope:• The quantity demanded decreases with
income.• The income elasticity of demand is
negative.
![Page 15: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/15.jpg)
An Inferior Good
Hamburger (units per month)
Steak(units per
month)
15
30
U3
C
Income-ConsumptionCurve
…but hamburgerbecomes an inferior
good when the incomeconsumption curvebends backward between B and C.
105 20
5
10
AU1
B
U2
Both hamburgerand steak behaveas a normal good, between A and B...
![Page 16: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/16.jpg)
Individual Demand
• Engel Curves– Engel curves relate the quantity of
good consumed to income.– If the good is a normal good, the
Engel curve is upward sloping.– If the good is an inferior good, the
Engel curve is downward sloping.
![Page 17: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/17.jpg)
Engel Curves
Engel curve isbackward bending for inferior goods.
Inferior
Normal
Food (unitsper month)
30
4 8 12
10
Income($ per
month)
20
160
![Page 18: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/18.jpg)
Price-Consumption Curve
Price Consumption Curve
Food (units per month)
Clothing(units per
month)
4
5
6
U2
U3
A
BDU1
4 12 20
The price-consumptioncurve traces out theutility maximizing
market basket for thevarious prices for food.
![Page 19: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/19.jpg)
Individual Demand Curve
Demand Curve
Individual Demand relatesthe quantity of a good thata consumer will buy to theprice of that good.
Food (units per month)
Priceof Food
H
E
G
$2.00
4 12 20
$1.00
$.50
![Page 20: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/20.jpg)
Derivation of Demand Curve from Price
Consumption Curve
Clothing (units per month)
Price of food
![Page 21: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/21.jpg)
Substitutes and Complements
1. Two goods are considered substitutes if an increase (decrease) in the price of one leads to an increase (decrease) in the quantity demanded of the other.
• e.g. movie tickets and video rentals
2. Two goods are considered complements if an increase (decrease) in the price of one leads to a decrease (increase) in the quantity demanded of the other.
• e.g. petrol and motor oil
3. Two goods are independent when a change in the price of one good has no effect on the quantity demanded of the other.
![Page 22: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/22.jpg)
Substitutes and Complements
• Substitutes and Complements– If the price consumption curve is
downward-sloping, the two goods are considered substitutes.
– If the price consumption curve is upward-sloping, the two goods are considered complements.
![Page 23: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/23.jpg)
The trust fund shifts the budget line
Example: College Trust Fund
P
Q Education ($)
OtherConsumption
($)
U2A
U1
A: Consumption before the trust fund
B
B: Requirement that the trust fund must be spent on education
C
U3 C: If the trust could be spent on other goods – i.e., unconstrained
![Page 24: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/24.jpg)
B
20,000
A
Gasoline(gallons per year)
Spendingon othergoods ($) 20,000
5,000
U1
C15,000
2,000
D
With a limit of2,000 gallons,
the consumer movesto a lower
indifference curve(lower level of utility).
18,000
U2
Example: Gasoline Rationing
Will the consumer be necessarily worseoff at D?
![Page 25: Consumer Demand Theory II Session 3, EA 4 th July, 2007 Prof. Samar K. Datta](https://reader034.vdocument.in/reader034/viewer/2022052522/5513e5f25503463a298b5ae0/html5/thumbnails/25.jpg)
Food for thought
• How would you display effect of income tax (proportional or progressive) with or without certain exemptions (e.g., on medical insurance)?
• How will commodity taxation change consumer equilibrium?
• How will income taxation influence labor supply?• How will consumer indifference curves look like
if one good is a bad, or both goods are bad?• Is it possible to display exchange between two
people having fixed endowments of two goods and no income, when there are no formal markets or prices to facilitate exchange?